What is AMM? A thorough explanation of the mechanism of Automated Market Maker.

Challenges of Traditional Market Making

In trading various assets such as stocks, currencies, and commodities, it is important for buyers and sellers to meet efficiently. In traditional financial markets, this role has been fulfilled by intermediaries known as market makers, who respond to trades at market prices. However, this system has its limitations. It requires management by a third party, incurs high fees, and also faces transparency issues.

New Solutions Proposed by AMM

Automated Market Makers (AMMs) have emerged to address these challenges. They replace traditional market makers with an automated protocol that determines prices through algorithms. By functioning as a key element of decentralized exchanges (DEXs), AMMs enable peer-to-peer digital asset trading without intermediaries.

AMM Pricing Mechanism

The biggest feature of AMM lies in its unique price formation method. It is a mechanism where asset prices are automatically adjusted based on the relative balance of trading pairs within the liquidity pool.

Specifically, let's consider a liquidity pool composed of DAI and ETH. When the demand for DAI suddenly increases, investors will deposit ETH and attempt to withdraw DAI. As a result, the supply of ETH in the pool increases, while the supply of DAI decreases. Depending on the market's supply and demand balance, the price of ETH will decline while the price of DAI will rise, resulting in an automatic adjustment.

Real-time Market Response

AMM utilizes a tool called price oracle to reflect the latest market trends. This allows for the real-time acquisition of asset price data from centralized exchanges, monitoring the divergence from market prices. When there is a discrepancy between the prices on DEX and centralized platforms, arbitrage opportunities arise, creating a positive feedback loop that enhances overall market efficiency.

Main Differences with the Order Book Model

In the order book model, buyers and sellers play a central role by presenting their own prices and matching with each other. On the other hand, AMM (Automated Market Maker) is a system where prices are automatically set based on the available resources in the liquidity pool. This difference allows AMM to provide a faster and more transparent trading environment.

Reasons Why AMM is Supported

Multiple factors such as a simple mechanism, low fee structure, and excellent usability are increasing support for AMM. The ability to trade in a trustless environment and the overall efficiency of the trading process have led to rapid expansion in the digital asset market. AMM can be seen as a technology that symbolizes the democratization of trading in the DeFi era.